Answer to Question #65176 in Economics of Enterprise for bushra praveen

Question

Question 3: The relationship between nominal exchange rate and relative prices. From the annual
observations from 1980 to 1994, the following regression results were obtained, where Y = exchange
rate of the German mark to the U.S. dollar (GM/$) and X = ratio of the U.S. consumer price index to
the German consumer price index; that is, X represents the relative prices in the two countries:
ˆYt = 6.682 − 4.318Xt
r 2 = 0.528
se = (1.22)(1.333)
a. Interpret this regression. How would you interpret r2?
b. Does the negative value of Xt make economic sense? What is the underlying economic theory?
(4

Answer 1

a) First of all we can mention that there are negative relation between Y and X. The regression is linear that can have its impact on the results we see in the regression. The value of r2 shows that X describes Y only for 53%, which means that there are other important variables absent in the regression equation. Standard errors may be smaller if the interval of observations will be increased.

b) The economic interpretation of this negative relations can be explained with help of the conception of PPP (Purchasing Power Parity): National currency will have the tendency of declining, if the inflation rate inside the country (USA in our case) is higher than the inflation rate in abroad (Germany in our case). In the regression mentioned above, we see that 1 point raise of X, ceteris paribus, will cause decline in 4.13 point of Y. The value of intercept probably shows the approximate average level of Y, so it is equal to 6.68.